26 U.S.C. §101(a)(1) provides as a general rule that "gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance, if such amounts are paid by reason of the death of the insured." As a result, those proceeds are not subject to federal income taxes. This is true whether the life insurance payout is from a term policy, group life policy or a permanent whole life policy. Permanent life insurance policies have the added benefit of having a cash value that grows over time. The policy owner can borrow money against the accumulated amount and even surrender the policy for its cash value (after paying certain surrender fees). Even better, the increased value of a permanent life insurance policy paid upon the death of the insured are still immune from federal income taxes.
However, like most general rules, there are exceptions that you should be aware of:
- Policy Transferred for Valuable Consideration: According to 26 U.S.C. §101(a)(2), if a transferee acquires a life insurance contract (by assignment or otherwise) in a transfer for valuable consideration (e.g. for cash or property), then the amount of the proceeds he or she can exclude from gross income shall not exceed the sum of the actual value of the cash or property exchanged, the additional premiums paid and certain other amounts. The excessive proceeds are taxable income. This does not apply to certain trades. According to 26 U.S.C. §1035(a)(1), no gain or loss is recognize on the exchange of a life insurance contract for another life insurance contract, endowment, annuity contract, or qualified long-term care insurance contract.
- Interest From Policy Proceeds: A beneficiary can elect to have the proceeds from a life insurance contract paid as a lump sum or paid in monthly or annual installments. The vast majority of beneficiaries elect the lump sum payment. However, a minority will elect installment payments and this election may cause the insurance company to pay accumulated interest on the withheld proceeds. According to 26 U.S.C. §101(c), interest payments on life insurance proceeds are taxable. The life insurance company will issue to the taxpayer and the Internal Revenue Service a Form 1099-INT reflecting these payments.
- Profit From Surrendering Cash Value Policy: If you surrender a life insurance policy for cash, you must include in your gross income any proceeds that are more than the cost of the life insurance contract (e.g. total premiums paid) pursuant to 26 U.S.C. §72(e)(3)(A). The life insurance company will issue to the taxpayer and the Internal Revenue Service a Form 1099-R showing the taxable portion of the proceeds.
- Dividends From Mutual Insurance Companies: Mutual Insurance companies are owned by policyholders and this may result in dividends being issued when the company makes a profit. Whether there is a taxable event or not depends on what the taxpayer does with the dividend. If the taxpayer elects to keep the dividend in the policy by either buying more insurance, reducing future premium loan payments or paying off a loan against the policy, then the dividend is not taxable pursuant to 26 U.S.C. §72(e)(4)(B). If the taxpayer elects to receive a check in the mail for the dividend, then income taxes will have to be paid on the gains. The life insurance company will issue to the taxpayer and the Internal Revenue Service a Form 1099-DIV showing the taxable portion of the dividend.
- Loans Against Cash Value Policy: Loans borrowed against a permanent life insurance policy are not taxable income. However, if the policy is surrendered or it lapses, then you will have to pay tax at ordinary gains tax rates on the loan balance plus interest (reduced by the total amount of premiums paid into the policy).
While life insurance proceeds may not be subject to federal income taxation, the amounts paid on the policy may subject the decedent's property to federal estate taxes. Three circumstances can cause life insurance to be included in the gross value to determine estate tax liability:
- The proceeds are paid to the executor of the decedent's estate. 26 U.S.C. §2042(1).
- The decedent possessed any incident of ownership in proceeds payable to a different beneficiary at the time of death. 26 U.S.C. §2042(2). An "incident of ownership" includes the power of the decedent to change or modify the policy in any manner.
- The ownership of the policy was relinquished or transferred away from the decedent within three years of the decedent's death. 26 U.S.C. §2035(a)(2).
Some life insurance policies can be several thousand if not millions of dollars. These policy payout amounts could cause the total value of the gross estate to exceed the basic exclusion amount of the estate tax exemption (In 2018, a taxpayer's basic exclusion amount is $11.2 million for an individual/$22.4 million for a married couple). Even if the beneficiary is the recipient of the proceeds, the distributed amount may have to be reduced by federal estate taxes paid against it.
So how does a taxpayer avoid federal estate taxes triggered by a large life insurance contract? There are some potential strategies available:
- Marital Deduction For Surviving Spouse As Beneficiary - 26 U.S.C. §2056 allows an unlimited deduction from the gross estate of a decedent for the value of any property interest which passes from the decedent to the decedent's surviving spouse. If the surviving spouse is named as the beneficiary and receives the proceeds of the decedent's life insurance policy, it is deducted from the gross value and not subject to estate taxes.
- Recruit Someone Else to Own The Policy - If an individual other than the decedent owns the policy and the decedent does not retain any incidents of ownership (e.g. cannot change beneficiaries or any material terms), then it is not countable in the decedent's gross estate. To avoid the appearance of any incidents of ownership, the not-yet-deceased should avoid directly making the premium payments. However, money could be gifted to the actual policy owner to offset the cost (An individual can gift up to $15,000.00 per year to another individual without triggering any gift tax liability).
- Create an Irrevocable Life Insurance Trust (ILIT) - An ILIT can take ownership of an existing life insurance policy or purchase the policy directly. The trust must be irrevocable, meaning you give up the power to change the terms of the trust or dissolve it. You cannot be the trustee of your own ILIT as that would create a prohibited "incident of ownership". The policy, as owned by the ILIT, can pay proceeds to beneficiaries and not be counted in the gross value of the decedent's estate (provided that the estate is not the beneficiary of any proceeds).
If you have further questions about the effect of life insurance policies on your income tax or estate tax liability, do not hesitate to contact the experienced attorneys at Kershaw, Vititoe & Jedinak PLC.